Nonprofits: Avoiding the Snares of Unrelated Business Income (UBI)
As nonprofits continue to look for ways to enhance or diversify revenue streams, the possibility of generating unrelated business income (UBI) increases. UBI rules are complex, but knowing the basic framework of the regulations can help your organization escape their hidden snares. What may seem like a cut and dried choice can change when the facts and circumstances are analyzed.
Whether your tax-exempt organization is religious, social service, higher education, an association, or other entity, you should be aware of what constitutes UBI and how it should be assessed. In some cases, tax must be paid on income that is not substantially related to an organization’s exempt purpose. Various regulations, along with exclusions and exceptions, form the framework for addressing the tax issues.
Trade or business: Generally, any activity for the production of income from the sale of goods or performance of services
Regularly carried on: Frequently and consistently pursued in a manner similar to commercial activities
Unrelated to exempt purpose: The purpose on which the organization's exempt status is based
All UBI is not created equal
While receiving revenue classified as unrelated business income is not in itself detrimental to a tax-exempt organization, there are potential consequences of these funding sources. As mentioned, UBI may result in the assessment of federal and state income tax and may impact whether the organization pays property or other taxes to a local jurisdiction.
Many exempt organizations are fearful of generating any UBI, believing that its mere existence jeopardizes the organization’s tax-exempt status. In reality, the income itself usually does not threaten an organization’s status. However, there may be consequences if the unrelated activity that generated the income is significant and it is determined that the organization is no longer organized and operated exclusively for an exempt purpose.
In recent years, the IRS and many states have been more active in scrutinizing unrelated business income activities. During the fiscal year ending June 30, 2016, the IRS completed approximately 5,000 exempt organization examinations, with many of these audits uncovering noncompliance with unrelated business income tax (UBIT) regulations. Many states have also increased efforts to ensure compliance with state UBI regulations. This two-fold effort of regulatory scrutiny, along with the potential tax liability and revocation of exempt status, are solid reasons to actively monitor all sources of revenue.
To help monitor activities and determine whether Form 990-T must be filed with the IRS, here are some common revenue sources that have been classified as unrelated in the past and, depending on the circumstances, could be again.
Services provided to other entities
It is not uncommon for exempt organizations to enter into arrangements to provide services to other entities. For example, a nonprofit entity might provide marketing services for a strategic partner that is looking to expand service offerings to its members. While some services may fall within the mission of the organization or be rendered in a manner in which the entity lacks a profit motive, many organizations cannot rely on these exceptions. When an organization receives revenue from the rendering of services, and the performance of those services does not further the tax-exempt mission of the organization, the income may be classified as UBI.
Conventional and online advertising
The sale of advertising in an exempt publication (such as a trade journal or newsletter) or on an organization’s website is typically considered UBI since the advertisements promote the business of the advertiser and not the tax-exempt entity. It is often argued that this activity is not unrelated business income because it is not “regularly carried on” or lacks a profit motive. Even so, advertising contracts should be analyzed to make sure the income is properly classified.
Tax-free corporate sponsorship or advertising?
Nonprofit organizations that receive corporate sponsorship payments need to determine whether the revenue is a tax-free sponsorship (charitable contribution) or if it should be classified differently when other benefits are provided to the sponsor. Although not all benefits provided to a sponsor would be deemed to generate UBI, a benefit such as advertising may. And while it may be the intent that a sponsorship payment be treated as tax free, advertising could be an unintended consequence to the nonprofit. Best practice when developing and implementing a sponsorship program would be to craft the agreement language to ensure that the intended outcome is obtained.
Passive royalties from licensing agreements
The licensing of an organization’s intangible property, such as its name or logo, is deemed to be a passive royalty and is excluded from UBI. However, it is not uncommon for royalty agreements to contain provisions that require the exempt organization to perform services for or promote the organization licensing the intangible asset. When this type of structure occurs, the income may be considered unrelated. Any organization choosing to enter into a royalty agreement should address the specifics of the arrangement to ensure a complete understanding of potential consequences.
Income from controlled organizations
Certain payments from controlled organizations are subject to regulations under IRC Section 512(b)(13). This generally includes interest, rent, royalty, or annuity payments from the controlled entity. An arrangement where a nonprofit owns a building and rents space to a for-profit subsidiary would generate payments that may be considered UBI from a controlled organization. That income could create a tax liability. While the definition of control, for this purpose, is dependent on the structure of the organization, these payments should still be reviewed to determine how they should be classified.
Income from S corporations
With the transfer of wealth that is occurring in today’s society, many exempt organizations are receiving interests in S corporations through donations or bequests. Oftentimes, an organization will accept this type of contribution without realizing the full tax implications. All items of income, deductions, and other amounts reported on a shareholder’s Schedule K1 are subject to UBIT. In addition, the gain or loss from the sale of S corporation stock is also considered UBI.
Income from partnerships
Investment portfolios of exempt organizations continue to become more diversified and complex, and UBI may be generated when an exempt organization is in a partnership that undertakes activities unrelated to its exempt purpose. The flow-through nature of a partnership requires that the parties characterize income the same as the underlying entity. Therefore, even the tax-exempt partner must include the income or loss from unrelated trade or business activities conducted within a partnership in its computation of UBI. Other tax obligations may occur with these types of holdings.
IRC Section 514 requires certain items of income to be included in the computation of UBI when the income is derived from debt-financed property. To be classified as debt-financed property, the property must be held for the production of income and subject to acquisition or improvement indebtedness. Most commonly, the debt- financed property rules apply to the rental real estate. However, the rules may apply to royalties or other investment income that has outstanding acquisition indebtedness.
How we can help
While this is not an exhaustive list of potential unrelated business income sources and activities, it does provide examples of revenue streams that may be subject to tax. CLA’s experienced nonprofit professionals can help you with various aspects of UBI, including determining what segments of your revenue may be considered UBI, the compliance requirements and potential impact of this income, and planning strategies to help generate the funding you need to thrive.